Are Dividend Stocks a Good Substitute for Bonds?

The low interest rate environment we’ve experienced in recent years has been difficult for income-oriented investors. Traditional income sources, such as certificates of deposit (CDs), money market funds and bonds, are unable to offer the level of yields that many of these investors are seeking. There are many newsletters and articles that expound on the benefits of dividend paying stocks. Certainly the types of companies that pay dividends and the mutual funds and exchange-traded funds (ETFs) that invest in these companies have merit. However, investors seeking income need to understand that investing in dividend-paying stocks is different than investing in bonds. Financial advisors working with clients need to ensure that clients understand these differences.

Companies that pay dividends are still stocks and not bonds. While many of these stocks, especially those that consistently pay dividends, may be less volatile than some other equities they are still subject to many of the factors that impact the stock market as a whole. Take as an example 2008. That year the S&P 500 Index lost 37% while the Barclay’s Aggregate Bond Index gained 5.24%. (For more, see: The Risks of Chasing High Dividend Stocks.)

Lets look at dividend oriented ETFs. The Vanguard Dividend Appreciation ETF (VIG) lost less than the S&P but was still down by 26.63%. This ETF focuses on high quality large-cap stocks with a history of dividend increases. The Vanguard High Dividend Yield ETF (VYM), which focuses more on yield, lost 32.10% in 2008. While both ETFs outperformed the S&P 500, losses of this magnitude could be devastating for an income-oriented investor, especially a retiree. Was 2008 an extreme example? Yes, absolutely. Going forward, will bonds hold up like this in the face of rising interest rates? Perhaps not, but historically the volatility of bonds even at their worst has been far lower than that of stocks.

Another example of a flawed reliance on dividends is Exxon Mobil Corp. (XOM). The stock closed at almost $104 per share in mid-June of 2014. The stock is now trading below $75 per share. Someone who has held 100 shares over this time frame has received $499 in dividends while losing about $2,900 in the value of their investment. (For more, see: Exxon Mobil Stock: A Dividend Analysis.)

Back in the day when interest rates on money market funds and CDs were in the 4% to 6% range, fixed-income investors could get a decent return and reasonably expect to preserve much of their capital and live off of the interest. Today, with money market rates close to zero and other instruments at historically low rates, it is unrealistic for a retiree or other income-oriented investor to expect to live off the interest and not touch their capital. Investors looking for income need to move farther out on the risk spectrum. Options might include high-yield bonds, certain closed-end funds, preferred stocks and dividend paying stocks.

These and other options generally carry more risk than traditional bonds or money market instruments. Certain fixed-income annuities might also be considered, though low interest rates impact their returns as well. (For more, see: The Best Funds for Capital Preservation.)

Dividends on common stock are set by the corporation. While companies generally like to maintain their dividend payout ratio there are no guarantees here. The company could potentially run into cash flow problems or decide to use some of this cash to finance internal growth.

Perhaps a better approach than to focus on yield is to focus on your portfolio’s total return. Total return takes into account both appreciation and yield. Especially for retirees, total return could be a better alternative than taking on more portfolio risk in an attempt to gain additional yield. Today’s retirees can expect to live longer than prior generations and most need some degree of growth from their investments to make sure they don’t outlive their money. Even for younger investors, this approach makes sense. (For more, see: Yield vs. Total Return: How They Differ and How to Use Them.)

In the case of a retiree, it's possible to allocate portions of their portfolios for different purposes. The first portion would fund spending needs for the current year and perhaps two to five years more. This portion of the portfolio would be in cash or cash equivalents. The next portion would contain dividend paying stocks and other income generating and moderate growth type vehicles. Certainly any cash flow from this part of the portfolio could be used to replenish the cash portion. The last part of the portfolio would be for growth. This would contain stocks and other growth-oriented vehicles to help make sure the portfolio owner does not outlive his or her money. 

It has been a difficult period for investors seeking income. Some publications and advisors have suggested that dividend paying stocks are an alternative to more traditional fixed-income vehicles. The fact is that dividend paying stocks are still stocks and carry risks that exceed those of most fixed-income vehicles. Financial advisors can help clients trying to navigate this issue look at ways to achieve their goals while taking risks they are comfortable with. (For more, see: The Top Dividend-Paying Stocks of 2016.)